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4/23/2016

The Organic Panic

A growing demand in today’s market is the desire for organic
produce. The trend of the green initiative has slowly grown over the past
decades but is starting to gain serious momentum. Where there is a demand,
there will be businesses trying to capitalize on this demand. A recent article in the Huffington Post states
that Costco has now overtaken Whole Foods in the market of organic produce. Now,
the only problem that Costco faces is a shortage in supply.

Costco has established a large membership base through the
use of its two-part pricing and block pricing strategies. Costco’s focus is to
bring in high quality product at a low cost, and sell in high volume to make up
for the smaller margins. With Costco’s benefits it offers its member (cash
back, no questions asked returns, and low costs) a high percentage of their
members renew their subscription year after year. As Costco has stepped into
the organic market, the millions of customers have shown their preferences and
are purchasing even more organic food than can be supplied. What is Costco’s
response to this demand?

To help supply organic produce, Costco has made exclusive
deals with certain farmers to sponsor them and help subsidize their costs. Organic farming can be a long and expensive process to produce certified
organic food. Farmers live on such razor thin margins that this process, plus
the lower yield, can cripple most farming operations before they even harvest a
single crop. Most farmers cannot even take the risk to become certified. Costco
is attempting to shoulder some of this risk to help solidify its future supply
of organic goods. This only makes me wonder if, in the future, Costco will
expand its vertical integration to roll out its own Kirkland brand of organic
grown produce. As the demand for organic food increases, supply will only
become more scarce. Many businesses will have to take high risks to win in this
organic panic.

5 comments:

Interesting. Would you believe I did a paper that's theoretically similar to this for a Trade class in 1987-8? I never tried to develop it further or publish it though.

What Costco is trying to do here is to defray some of the fixed costs of the organic farmers.

From the farmer's perspective, this will push their ATC closer to their AVC. This increases the range of prices on the low end over which the farm remains profitable. That's a desirable thing for a partner to offer.

What's really interesting, though, is what this does the industry as a whole: helping existing individual farmers with their fixed costs will lead to free entry of new "unhelped" farmers. Here's how that works. Organic produce is a monopolistically competitive market: it isn't just produce, it's differentiable produce. Free entry pushes firms towards zero profits. In monopolistic competition, that's where demand is tangent to ATC along the left side of the curve. When Costco defrays some of the farmer's fixed costs, their ATC shifts down. Initially this creates profits for the farmer, but that signals potential entrants to become actual ones. Now, think about the point of tangency: when ATC shifts down, the new point of tangency must be on a demand that is shifted to the left. This makes the quantity at the new point of tangency smaller than before the defrayal of costs. But this all happens to individuals; the market demand hasn't changed at all. So, what we'll end up with is a market with more producers, but each one producing left. And since they're selling a differentiable product, the result is more varieties to choose from.

This is a very interesting topic that I'm sure hits home with most of us, or at least those with kids. Organic foods, and their place in our pantry, have been a subject of debate in our household for some time now. It seems that the organic panic has grown into the organic tsunami, which I feel is partially driven by creative marketing campaigns. This marketing seems to be directed towards ones responsibility to be health conscious. My wife and I both agree that filling the bodies of our growing children with chemicals can't be good, and environmentally speaking, it's more responsible to refrain from dumping damaging chemicals into the environment.

As far as grocery stores that are capitalizing on the organic panic, HEB and Costco are only a few of the many in our local market trying to differentiate themselves by offering a growing selection of organic foods. We've even recently noticed Walmart refreshing its produce section with organic produce and marketing swag. The overall cost of food continues to rise due to other economic factors as well, but it seems that the cost of organic products are especially high and highly profitable. This could be partially due to the fact that farmers producing these crops are unable to produce as much volume as traditional farmers that use insecticides. As the demand goes up for the organic products, the supply of the product becomes scarce, which in turn drives the price up. It's then up to the marketing teams to help consumers justify the higher price of organic produce.

With that said, some of that marketing has hit home, and over time our family has justified the higher cost of organic produce on certain items. For example, we purchase organic strawberries and apples since we consume the skin of these fruits that would historically be saturated with insecticide. But to save money, whether it's justified or not by health reasons, we have continued purchasing other non-organic produce such as bananas since the peel is not consumed. Hopefully over time more suppliers of organic foods will be enticed by higher profits to enter the market, and a shift in the supply curve will drive prices down. Then we can hopefully make the decision of which organic foods to purchase over non-organic foods less driven by cost, and more on the health benefits of consuming organic produce.

This was an interesting topic that hasn't had much effect on me. Although I understand that organic food is the healthiest option, I have had trouble being able to afford such pricey items while still being in college. When I start making money that might change. Costco is making a smart move with their procurement of organic farms. The hot topic, as of late, has been to push for a less vertically integrated system. This way companies will be able to spread the risk in case of something going wrong in the market. However, I think this is a good move for Costco. Their produce section makes up only a fraction of all their sales. If something were to go wrong in produce they would be fine. It would make sense for them to be partial owners of organic farms to create a greater supply for customers. Once the supply is increased hopefully the price will go down and I will be able to hop on the organic train.

Chris: 47/50 you wrote "ones responsibility" when it should have been "one's responsibility". (-3)mholley: 50/50

It is correct that organic produce is more expensive. This is mostly because it is a less efficient method of production. It is also because traditional production is closer to perfect competition, while organic production is closer to monopolistic competition (where mark-up over marginal cost is possible). I do not think high profits have much to do with it: free entry and exit operate very strongly in all agricultural sectors. There may also be some effect from demand shifting to the right, but I'm guarded about this because we don't know if supply isn't shifting to the right at the same time. Chris mentions the first and last of these.

I have just one tidbit to add about mholley's comment. While produce may be a small part of the revenue stream of Costco, produce sections are a source of high (accounting) profits for groceries. So I think if something does go wrong, this will not be a small thing for Costco.

FWIW: Both commenters mention marketing. The organic movement devils business professors a bit. The actual evidence that organic produce is better is rather weak. But clearly the marketing is working. No offense Chris, but "saturated with insecticide" is mighty strong language, and mholley didn't qualify "healthiest option" either. Part of what's going on here is that guerrilla marketing, such as encouragement of word-of-mouth, is protected as freedom of speech while commercial advertising is not (and must be backed up with hard facts to avoid lawsuits). In some sense, such speech is relatively harmless, because it's not that much different than the sort of things sports fans say about their favorite team. But what economists worry about is if, absent the perception, the opportunity cost of buying organic exceeds the benefit.

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Anyone ready for some super weird trivia?

In the San Francisco scene of the mid to late 60's, people did a lot of LSD. Initially it was legal, but after it was made illegal, most of this was manufactured by a brilliant oddball with some chemistry experience named Owsley "Bear" Stanley. He was also instrumental in many of the early developments of the Grateful Dead (which is why the band and its descendants use the dancing teddy bear motif, and its followers are known for LSD use). Stanley was rich to begin with, and while no one ever accused him of making a lot of money on LSD, no doubt he made some. LSD also began to get a reputation as a harsh drug that carried harsh penalties. So people who wanted hallucinogens started looking for legal alternatives. In southern California they turned to peyote, and in northern California and Oregon — where an agricultural commune culture was developing — turned to "magic" mushrooms (which occur commonly in moist, temperate, climates around the world). When these were made illegal too, both were then marketed as organic alternatives to the chemical lab sourced LSD.

That's the origin of the organic market. Of course, you can't really say that in the produce section these days.

Who knew?

P.S. Interestingly, Stanley was (if I can coin a phrase) anti-vegan. He claimed to have consumed no plant matter since 1959 until his death in a car accident in Australia a few years back. Weird, huh?